On the Concept of Foreign Exchange Multiplier—A Correction

In an earlier issue of this journal, Diamond [1] has argued that in developing countries increased imports may have an inflationary rather than a deflationary impact on the economy. His reasoning is based on the fact that developing countries are faced with short supplies of imported inputs and not with a deficient demand. An increase in the imports of intermediate goods results in increased production and higher G.N.P. The ratio of the increase in output to the increase in the imports is termed foreign exchange multiplier by Diamond. Diamond’s analysis is quite useful as it enables one to determine the increase in output when foreign exchange constraint is relaxed in a developing economy. However, his analysis suffers from two problems. First, the assumption that all of the increase in foreign exchange will be allocated to the imports of intermediate goods is unrealistic. Second, there is a mathematical error in his Equation 6 when he divides the output vector by an imports vector. In this note, the assumption that all of the increase in foreign exchange is allocated to the imports of intermediate inputs is relaxed. Diamond’s Equation 6 is corrected. It is further shown that for the computation of a foreign exchange multiplier for the economy as a whole one does not need inter-industry matrix and that information regarding the value added per unit of gross output is sufficient.